In this article we will look at one such categorization of debt mutual fund, based on its duration – Short Duration Mutual Funds.
We will understand what these funds are, their risk-return relation, as well as their advantages and drawbacks.
About Short Duration Mutual Fund
A Short Duration Mutual fund is a categorization of debt mutual fund based on its duration. Duration of a mutual funds represents the holding period of the securities comprised in its portfolio.
In other words, it means the time within which the debt securities would mature with complete redemption of principal and accrued interest.
A Short Duration Mutual fund invests in such debt securities that would make the Macaulay duration of its portfolio between 6 months to a year.
Securities Exchange Board of India (SEBI) has laid this out in its guidelines. Macaulay duration is the weighted average of the present values of cash flows of the fund.
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Where does Short Duration Funds invest in?
A low duration fund, being a debt mutual fund can invest in several types of debt securities.
As the holding period for these funds are low, they may invest in slightly lower rated bonds (AA and below) to maximize their returns.
Lower rated bonds are likely to be offering higher interest rates. As Short Duration Funds hold securities that have a short time to maturity, the risk of default from the securities is lower.
In this way fund managers of such funds can look to maximize their returns for the short term.
Comparative risk of Short Duration Mutual funds
Owing to their short-term nature, these funds tend to have lower risk than longer duration funds. They also have considerably lower risk than equity and hybrid funds.
These funds do however have higher risk than overnight funds and liquid funds and higher risk funds discuss interest risk.
Comparative returns from Short Term Mutual funds
Short Duration Mutual funds seek to earn modest returns. They do however adopt a strategy based on their low duration to maximize their returns.
These funds can invest in lower than AA rated bonds for earning higher interest rates.
Although these bonds typically carry higher risk, the risk can be somewhat offset by the fact that these funds have a low duration.
Short Term Mutual funds can thus produce higher returns that overnight or liquid funds but, lower returns than other classes of mutual funds such as equity or hybrid.
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Who should Invest in Short Duration Mutual Funds?
The unique features of Short Duration Mutual funds make them amenable to certain type of investors. These include:
- They have a short-term maturity period. This makes them suitable for investors who are looking for temporary parking of their funds for a period of less than a year.
- Investors should however keep a timeline of more than 3 months while investing in these funds. For shorter than 3 months timelines, they should opt for liquid funds.
- These funds are suitable for investors looking out for slightly better returns than traditional saving instruments such as savings accounts and bank fixed deposits. Such investors can take on the moderate risk of Short Term Funds to earn better returns.
- Short Duration Funds are also used as a pathway to invest in other, often more lucrative funds through Systematic Transfer Plans (STP). Under STP, investors can invest lumpsum into Short-Term Mutual funds. From here, amounts are systematically transferred to other equity or hybrid funds for investment.
Things to consider before Investing in Short Term Mutual Funds
Before you invest in Short Duration Funds, keep certain factors in mind. These include:
As Short Term Funds tend to invest in lower rated bonds as well, it is important to check the strength of securities in which the funds have invested.
Analyzing the portfolio of the fund as well as regularly monitoring its ratings is advisable so as to keep the risk levels in check.
All fund houses charge a fee for managing their mutual funds. This fee is represented as a % of the total assets under management and is termed as expense ratio.
As the investable time frame is low in such funds, there is limited opportunity to cover up the expenses through higher returns.
It is thus advisable to seek out a fund that has a comparatively lower expense ratio than other funds in the same category, so as to maximize the ultimate return on investment in this fund.
As there is a risk-return trade-off involved in Short Duration Mutual funds, there is a role to be played by the fund managers.
The fund manager of each different fund house brings a different expertise and experience.
Thus, it is important to undertake a comparison of peer performance of different Short Term Mutual funds before selecting the fund to invest in.
Taxation of these Funds
The taxation of Short Duration Mutual funds is like debt mutual funds. The redemption proceeds are most likely to credit to the investor within 3 years.
This makes the redemption proceeds subject to short term capital gains as the holding period is less than 3 years.
Short term capital gains are taxed at the tax rate applicable to the investor depending on the tax slab that they fall in. No indexation benefit would then be available.
Short Duration Mutual funds are not subject to any tax deducted at source.
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Benefits of investing in Short Duration Mutual Funds
Here are the various benefits of Investing in Short Duration Funds –
One can earn higher returns as compared to returns earned by traditional saving instruments.
They can thus give better returns to investors than what they would earn by keeping money in their savings bank accounts or investing in fixed deposits.
Limited Risk Levels
Short Duration Mutual Funds have moderate risk levels. This is because they invest in debt securities that typically earn stable and consistent income.
Their values are not dependent on stock market changes. This makes the risk levels of Short Term Mutual funds limited.
Drawbacks of Short Term Mutual funds
Here are the drawbacks which anyone should consider before investing in Short Term Funds –
Interest Rate Risk arising due to Volatility Conditions
It is subjected to interest rate risk that arises with changes in market interest rates.
In case of the market interest rates risk, the value of the holdings of these funds which are offering lower interest rates will reduce.
This is risk is somewhat alleviated as these funds are held for a short duration.
Default Risk on Account of relatively Low Rated Investments
As it tend to invest in marginally lower rated bonds, they run a higher risk of default.
There are chances that these invested bonds may be unable to meet their principal or interest servicing obligations. This can reduce the value of Short Duration Mutual funds.
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Short Duration Mutual Funds – Conclusion
All in all, Short Duration Mutual funds are a suitable avenue if you are looking to fund your short-term goals.
Money can be kept in Short Term Funds for a short term to earn slightly better returns. This can be achieved with limited risk and good liquidity.
In this way you can have good liquidity to meet your short-term goals whilst still earning slightly better returns on your investments.
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